The long shadow of Russia's second economy

By Paul Goble, Asia Times, 30 September 1999

Russia's second or shadow economy is now so large and pervasive
that it is likely to define whatever kind of legal economic
arrangements do emerge in the country in the future.

That is the unsettling conclusion of a recently published study
prepared by the Russian Academy of Sciences' Institute of
Socioeconomic Problems of the Population.

According to the authors of the study, the earlier conviction in both
Moscow and the West that “the scale of the shadow economy would
diminish and the legal economy would grow as the country moved in the
direction of capitalism” has not proved to be true.

Instead, they suggest, “just the opposite has taken
place.” In 1990-1991, 10-11 percent of the country's GDP was
produced by the shadow economy, but the illegal or semi-legal second
economy accounted for 27 percent of GDP in 1993, 46 percent in 1996,
and quite possibly more than 50 percent in more recent years.

Because of the size of this sector of the economy and because it is so
interwoven with the legal economy, the new study argues that the rules
of the game within the shadow economy are far more likely to define
behavior within what will emerge as the legal economy rather than be
fundamentally transformed by that legalization.

And because this is so, the study suggests, it is critical to
understand both where the shadow economy came from, what the current
rules of the game are, and how these are likely to play a role as
Russia moves to legalize many economic activities that are now part of
the second economy.

According to the study, the second economy was relatively small during
most of the Soviet period. Its authors cite a Western study that found
that the shadow economy produced only 3-4 percent of Soviet GDP in
1973—a percentage far smaller, the study notes, than in many
developed market economies.

Until nearly the end of the Soviet period, the shadow economy
performed two fundamental functions: it compensated for shortcomings
in the functioning of the official legal economy, and it provided a
field of activity for entrepreneurs who could not easily fit into
Soviet institutions.

With the collapse of communism, these two functions fused,
particularly under conditions of what many have described as
“incomplete” marketization, a system in which the role of
the state or at least of its agents remained large and hence the
social space for illegal activities actually grew.

The Moscow study suggests that the shadow economic system now has six
defining features: close ties between bureaucrats and entrepreneurs,
continuing interference by the state in the economy, preservation of
many old monopolies and the growth of new ones, high and repressive
taxes that are easy to avoid, the impoverishment of much of the
population, and the absence of a legal framework for the economic
transformations that have occurred.

The study continues by observing that even though “approximately
two-thirds of all enterprises are almost unaffected by the shadow
economy in their activities, those firms that are involved are heavily
so.” Moreover, the behavior of these firms casts a long shadow
on all the others, in many cases because the shadow economy produces
higher incomes for those who are involved it.

And the report draws three conclusions: First, until legal economic
activity produces more wealth than the semi- legal or illegal
activities of the shadow economy, many people will continue to turn to
the shadow economy to seek their livelihood.

Second, the percentage of the country's GDP produced by the shadow
economy will begin to fall only when the country enters a long period
of stable economy growth, during which enterprises will be able to
renew their technologies and thus generate real wealth on their own.

And third, even when this change takes place in Russia—and the
authors are optimistic that it will—many of the values and
patterns of the shadow economy will help to define the values and
patterns of the future legalized market economy there for many years
to come.